Massimo Acquaviva, co-founder of 2R Capital Investment Management Limited, is a seasoned business leader with a strong interest in talent acquisition and investment training. This article delves into the concept of due diligence and its role in analyzing and mitigating risks associated with investment and business decisions.
Due diligence is a thorough examination process involving audits, investigations, or reviews to confirm the details and facts of a subject under investigation. In the realm of finance, due diligence is a crucial step in assessing financial records before entering into transactions with other parties.
Individual investors often conduct due diligence on stocks they are considering for investment, using publicly available information. This same approach can be applied to various forms of investment by examining a company’s financial data, comparing it over time, and benchmarking it against competitors in the industry.
The term “due diligence” finds application in various contexts, such as reading product reviews or conducting background checks on potential employees. In the United States, due diligence became a standard practice after the enactment of the Securities Act in 1933. This legislation made it mandatory for securities brokers and dealers to provide full disclosure of all material information about the securities they were selling. Brokers and dealers who failed to disclose this information could face criminal prosecution.
Recognizing that requiring full disclosure could unfairly expose brokers and dealers to prosecution for information they were unaware of at the time of the sale, the Securities Act included a legal defense. As long as brokers and dealers conducted due diligence when investigating companies whose stocks they were selling and disclosed the results, they could not be held liable for information not discovered during the investigation.
Today, due diligence is conducted by broker-dealers, fund managers, equity research analysts, individual investors, and companies considering the acquisition of another firm. For individual investors, due diligence is optional, but broker-dealers are legally obligated to perform due diligence on securities before selling them.
There are different types of due diligence, depending on the context. Some of the primary types include:
Legal Due Diligence:
Ensuring a company’s legal, compliance, and regulatory aspects are in order, including matters like proper incorporation and pending litigation on intellectual property rights.
Tax Due Diligence:
Assessing a company’s tax obligations, potential back taxes, and strategies for reducing future tax liabilities.
Financial Due Diligence:
Involving audits of a company’s financial records to identify irregularities and ensure its financial stability.
Commercial Due Diligence:
Evaluating a company’s competitive position, market share, growth opportunities, supply chain, and overall operations, including IT, human resources, and management.
Due diligence can be categorized as “hard” or “soft” based on the approach taken. Hard due diligence involves quantitative analysis of financial statements, including income statements and balance sheets. This involves using financial ratios to assess a company’s financial health and make predictions for the future. It relies on mathematics and legalities and helps identify accounting inconsistencies and other issues.
Soft due diligence, on the other hand, is a more qualitative approach that considers factors such as the quality of management, key employees, and customer loyalty. It takes into account aspects not reflected in numbers, such as leadership, corporate culture, and employee relationships. Experts suggest that more than 70% of mergers and acquisitions fail due to neglecting these human elements.
Due diligence is a widely used term across various disciplines, particularly in the corporate and legal fields. In the business context, it refers to the investigations conducted by interested parties, like private equity or venture capital firms, to evaluate companies earmarked for potential investment and merger or acquisition targets. In rarer cases, due diligence may describe investigations carried out by a buyer into a seller, a process sometimes known as “sell-side due diligence.”
Mergers and acquisitions have a reputation for a high failure rate, with up to 90% resulting in corporate separations. Extensive and rigorous due diligence increases the chances of success for both parties involved. From a corporate perspective, due diligence offers the acquiring party an opportunity to identify and assess liabilities, risks, and potential issues with the target company before finalizing the transaction. This can help prevent losses and negative publicity in the future.